Dear reader, you already know this: The Daily Reckoning holds no love for the central bankers of the world. But we’ll grudgingly credit the Bank of England for releasing a paper on how the modern financial system creates money. It removes the fantasy most people have about how the system works. Read it if you can. But it boils down to this: banks create credit. They do not lend the money deposited by savers.
The fantasy is that we all diligently work hard, save our pennies and then the banking system lends this on at interest to productive enterprise. The reality is that banks create bank deposits when they make loans. The loan brings new money into existence. Money from nothing. Or as the paper puts it, ‘For this reason, some economists have referred to bank deposits as "fountain pen money", created at the stroke of bankers’ pens when they approve loans.‘
One role of the central bank in our current system is to keep a rein on this credit creation. That’s why you might have seen the recent story about the Reserve Bank of Australia considering additional measures to limit risky lending in the Australian housing market. Here’s a clip from The Age last week:
‘The Reserve Bank’s preferred way of reining in a harmful housing credit boom would be to force banks to impose higher "buffers" when testing how borrowers coped with higher interest rates, new documents show.
‘But unlike its counterpart in New Zealand, Australia’s central bank appears unconvinced about restricting loans with high loan-to-valuation ratios.
‘With banks competing fiercely to sign up new borrowers, documents released under Freedom of Information laws on Monday show the Reserve Bank has examined various options for limiting riskier lending.‘
If you feel a sense of comfort or security at the idea of more regulation preventing banks from lending money and making it easy for people to get credit until they blow themselves up, we urge you to heed the work of our colleague Phil Anderson.
He’s studied real estate and banking going back 200 years, primarily in the USA. And one conclusion is this: in the wake of every banking crisis for two centuries, the authorities took steps to ‘stabilise’ the system and prevent a future crisis with additional regulations and controls. And for 200 years, major banks have kept collapsing with regular monotony – roughly every 18 years. Indeed, the scale and numbers get bigger over time.
Take the following examples from Phil’s work since 1970:
‘In October 1973 the collapse of the US National Bank of San Diego was the biggest in 40 years.
‘An even bigger bank failure followed twelve months later, in October 1974, the Franklin National Bank of New York.‘
Then in 1989:
‘For the Bank of New England (BNE), the collapse of real estate values brought difficulties in the form of non-performing loans…The taxpayer funded bailout would ultimately cost $2.3 billion after the FDIC and Reserve Bank decided the bank was simply "too big to fail".‘
And in 2008:
‘The failure of IndyMac Bancorp is the second biggest bank failure in US history, and the largest regulated Savings and Loan institution failure.‘
Of course, we’re not suggesting the Australian banks are going to fall over any time soon. We’re just pointing out why you should be sceptical of any claims you hear from economists, politicians and bankers about how ‘risky lending’ is now contained, because they’ve been saying the same thing for decades, and been proven wrong at some point every time.
We vividly recall Trevor Sykes in his book The Numbers Game quoting the former Westpac Chairman Sir James Foots in the opening statement of the 1988 annual report, where Foots declared ‘a splendid performance‘ by the bank. It was after a 69% profit increase for 1987-88. What happened in the next four years? Westpac wrote off $6.3 billion in faulty loans and had to have a $1.2 billion rights issue to maintain its capital base. It almost went broke.
We don’t know much more about Sir Foots. But we’ll assume he was just not looking in the right place at the time. Ben Bernanke had the same problem. Even the idolised Warren Buffett said in 2007, ‘Subprime mortgages do not pose a huge danger to the economy, and it’s unlikely that this factor will trigger anything of a massive nature in the general economy.‘
Everything looks easy in hindsight, so we’re not laughing at these sanguine claims. But Phil’s work suggests banking failures will be here for a long time to come, as long as banks can create credit, especially against capitalised land value. This is how he called the GFC before it happened.
To find out more about how Phil views the economy, you should check out a free series of videos he’s doing with Dan Denning so you don’t get caught by these type of events. He says you’ll be alright if you time your investments within the rhythm of what he calls the real estate cycle.
Another way is to keep your eye on important charts. Phil has more on that in today’s other article…